MILAN, May 18 (Reuters) - Italy’s incoming government rattled investors with its plans for the financial sector on Friday which industry leaders said could stall a clean-up of bad debt and derail a tentative recovery.

Italian banks were laid low by a deep recession and the sector teetered on the edge of a full-blown crisis for years until last summer’s state bailout of Monte dei Paschi di Siena .

The plan signed off by leaders of the League and the 5-Star Movement, the two parties that won the most parliamentary seats in the March 4 election, called for Monte dei Paschi to be given a new “mission” to serve the community, scrapping its turnaround plan in a potential blow to euro zone stability.

The EU Commission urged Italy to stick to its commitments over the state-owned bank, saying it was monitoring the implementation of the rescue deal.

Italian lenders are under pressure because of their remaining large exposure to domestic sovereign bonds, whose yields jumped to their highest level in more than seven months on the spending-boosting plans of the new coalition.

They were also hurt by a reference to debt recovery rules in the plan, which hit loan collectors such as DoBank, Cerved and Banca IFIS as well, pushing the latter two to their lowest level in more than a year.

The new government pledged to abolish any rules that allow banks to claw back money from retail borrowers without previous judicial authorisation.

“If this means you need to get an authorisation before ringing up a borrower, then recoveries would become much lengthier, costlier and more uncertain,” said Christian Arsenio, Chief Executive of small debt collector Distressed Technologies.

“The price of soured debts would fall and the clean-up process banks have been going through would come to a halt.”

BAD LOANS LINGER

Italian lenders shouldered heavy losses to be able to rid themselves of troubled debt and a market for bad bank loans in the country has only recently started to gather steam.

Investors have bet heavily on Italian soured debt braving an inefficient judicial system where it can take years to seize assets.

Monte dei Paschi tapped a guarantee scheme introduced by Italy’s outgoing government to help banks shed impaired loans at higher prices. The scheme runs out in September and it will be up to the new government whether to renew it.

“It makes little sense what the programme says in relation to bad debts, but what’s scary is precisely the little knowledge those words betray,” the head of an Italian bad loan specialist said, requesting anonymity due to the sensitivity of the issue.

The government pact mentions retail borrowers while more than two thirds of Italy’s soured bank loans are corporate.

Italian banks have reduced their stock of domestic government bonds after the sovereign debt crisis but Creval and Banco Popolare both hold Italian bonds equivalent to more than twice their core capital, according to analysts.

Shares in Monte dei Paschi fell 0.9 percent after an 8.9 percent drop the previous day. The stock is down nearly 40 percent since returning to trade in Milan following a 10-month hiatus.

For years the biggest threat to Italy’s financial stability, Monte dei Paschi is slowly trying to recover from years of mismanagement and huge loan losses after an 8 billion euro rescue last year which handed Rome a 68 percent stake and also turned some bondholders into shareholders.

The League’s economic spokesman Claudio Borghi on Thursday said the new mission for the bank would entail dropping a plan to close branches, which Monte dei Paschi is pursuing to meet profit targets agreed with EU competition authorities.

Borghi said a new government would likely replace current Chief Executive Marco Morelli, who last week beat forecasts with a first-quarter net profit of 188 million euros thanks to cost cutting and shrinking loan losses.($1 = 0.8486 euros) (Additional reporting by Francesco Guarascio in Brussels, Danilo Masoni in Milan and Maiya Keidan in London, editing by Louise Heavens and Elaine Hardcastle)